Hillary Clinton said Israeli plans to build new settlements on occupied territory would 'set back the cause of a negotiated peace'. Photograph: Saul Loeb/AFP/Getty Images

The US secretary of state, Hillary Clinton, and British foreign secretary, William Hague, have launched attacks on an Israeli decision to build fresh settlements on occupied territory in the West Bank.

The US, with Israel, strongly opposed that move, while Britain abstained in the vote. But now both countries have criticised the Israeli settlement decision, saying it hurts the chances of a two-state solution and the search for peace in the troubled region.

"Let me reiterate that this administration, like previous administrations, has been very clear with Israel that these activities set back the cause of a negotiated peace," Clinton said, in remarks delivered at the Saban Center think tank in Washington on Friday.

Hague said he was "extremely concerned" at the plans, which have been reported in the Israeli press as including a four-square-mile area just east of Jerusalem that is seen as vital to keeping open a viable land corridor between the city and any future Palestinian state.

Hague asked Israel to reverse the decision and said the prospect of a successful two solution was receding. "Israeli settlements are illegal under international law and undermine trust between the parties," he said in comments Saturday. "If implemented, these plans would alter the situation on the ground on a scale that makes the two-state solution, with Jerusalem as a shared capital, increasingly difficult to achieve."

Hague added: "They would undermine Israel's international reputation and create doubts about its stated commitment to achieving peace with the Palestinians."

Israel had strongly opposed the Palestinian bid for improved recognition at the UN, saying that the tactic was a blow for peace negotiations. It had secured strong and vocal support from the US, its traditional ally, and a handful of other nations, but was unable to derail the move which was celebrated wildly on the streets of the West Bank.

Palestinian politicians reacted to the new settlement decision with dismay. "This would be the last nail in the coffin of the peace process," the Palestinian prime minister, Salam Fayyad, told Sky News.

The firm US and British line on the Israeli decision is unlikely to mark any real shift in allegiances or policy. Clinton backed up her criticism of Israel with another strong admonition of the Palestinians and said that they had acted wrongly and unilaterally in gaining improved recognition at the UN.

"Palestinian leaders need to ask themselves what unilateral action can really accomplish for their people. President [Mahmoud] Abbas took a step in the wrong direction this week, to say the least. We opposed his resolution," Clinton said.

The fresh spat over settlements comes at a time when all sides appear to regard the prospect of a peace settlement in the region as a distant dream. Any future Palestinian state remains deeply divided between the more moderate and secular rule of Abbas in the West Bank and the militant Islamic group Hamas, which governs in the tiny and isolated Gaza Strip.

In Friday's address, the US secretary of state said Hamas had "condemned those it rules to violence and misery" and now faced a choice.

"Hamas knows what it needs to do. If it wishes to reunite the Palestinians and join the international community it must reject violence, honor past agreements with Israel and recognize Israel's right to exist," Clinton said, adding: "America has showed that it is willing to work with Islamists who reject violence and work towards real democracy, but we will never work with terrorists."

Despite the criticism over settlement building, Clinton reiterated American support for its traditional Middle East ally.

"Americans honor Israel as a homeland dreamed of for generations and finally achieved by pioneering men and women in my lifetime," she said. "What threatens Israel threatens America. What strengthens Israel strengthens us."

Israel agreed to freeze settlement construction under the Roadmap For Peace plan in 2002. But it has failed to comply with that commitment despite repeated and widespread international condemnation.

Fresh trouble continues to break out in Gaza, after Hamas and Israel spent eight days trading rocket and missile fire earlier this month.

That conflict ended with an Egyptian-brokered truce but there have been repeated flare-ups since. On Saturday a Palestinian who was shot and wounded by Israeli troops on Friday, while protesting at the Gaza Strip boundary fence, died in hospital. Five others were also wounded in the incident.